This is the easiest way of documenting income and expenses, in fact, it's how most of us manage our personal finances. In cash accounting, the only time income is recorded, or expenses deducted is when the actual money is exchanged. Therefore, if the company receives a bill for the purchase of equipment in January, but does not make a payment until February, the payment is recorded in February. Likewise, if services are performed, or products sent, in January, but payment isn't received until March, the income is recorded in March.
The benefit of this method is that it allows business owners to see a clear cash flow snapshot at any given moment. It's also fairly easy, and takes a minimal investment of time. The drawback is that it distorts both income and expenses, making it difficult to see the true financial health of a company. For example, if services are performed in December, but payment isn't received until January, the income is not reported until the following year. When expenses are handled in this manner, it reduces the amount of deductions for the previous tax year.
The key difference between cash and accrual accounting is the timing of the entries into the books. For accrual accounting, income is recorded when it is earned, even if there hasn't been any cash exchanged. The income is counted as an account receivable, and estimated profits are attributed to the owner's equity, or retained earnings account. Likewise, liabilities such as utility bills, insurance premiums, and credit purchases are input when the bill is received, or the purchase is made. Therefore, if the utility bill for the previous month arrives on the third of the following month, the expense is recorded then.
There are many advantages to the accrual method, but most importantly, it follows the generally accepted accounting principles (GAAP) that business financial statements require. Therefore, it is simple to produce reports such as a balance sheet, profit and loss statement and cash flow statement. While it is more time-consuming to maintain this method, it helps with big decisions such as hiring, expansion, or purchasing equipment. There may also be tax benefits such as claiming a full deduction on an equipment purchase made at the end of the year, versus waiting until payments are made.
Setting up your accounting method early on in your company's evolution is essential. Commonly, smaller businesses opt for the cash method, while larger companies use accrual accounting. If you have questions about which method of accounting is best for your business please contact us. We will be happy to assist you in any way that we can.